Bottom-Fish Only in Deep Waters

 | Oct 27, 2011 | 2:30 PM EDT
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Europe finally agreed on something that resembles a deal to fix some of its nations' problems. Some believe it might be enough, while others think that Italy and Spain will be next -- and that the bandage is not large enough to solve the real problems. The market seems to like the plan as we have a strong early morning rally taking place as I write this. I have no idea exactly how the proposed bailout package works out and I suspect no one else really does either. October has been an interesting month in the stock market -- to say the least.

But one lesson might be lost in the aftermath of today's "Blow Your Face Out" rally and the failure to learn it could leave some investors singing "Musta Got Lost." (Any J. Geils Band fans out there?)

We have seen many of the momentum and growth darlings get smacked in the face and roll over in the past couple of months. Former stock market superstar Netflix (NFLX) has been the most dramatic, as its shares have lost two-thirds of their value since the end of July. The stock fellow contributor Tim Collins and I love to hate, Green Mountain Coffee Roasters (GMCR), has also finally rolled over and fallen by about 50%. That stock was helped along by the every bearish presentation by hedge fund star David Einhorn. He gave a 100-plus page bearish presentation on the company earlier this month at the Value Investing Congress in New York. Even Amazon (AMZN) has shown cracks in its armor and dropped sharply since missing their earnings estimate. It seems that even the allegedly bullet proof growth stocks can and do go down and when they do they often destroy capital permanently.

 A lot of the chatter on the TV and the Internet right now is the question of when to get back into these names. One noted value manager is already said to be buying Netflix as the stock has moved lower. I think this is a huge mistake. When a growth and momentum darling missteps or misses its earnings estimates, these stocks tend to go lower and take far longer to recover than anyone thinks they will. Institutions who owned the stock on hopes of never-ending growth will be persistent sellers for several quarters, as conditions fail to improve as quickly as had been hoped. A stock trading at high multiples of earnings or asset value has a long way to fall before the valuations approach the rational worth of the business.

If you look at some of the growth stocks that broke in the past, you can see that it is rarely a V-shaped recovery. Cisco (CSCO) is my favorite example of a busted growth stock. This is a great company that still dominates its industry. Once investors lost their love for the stock back in 2000 the stock lost about 80% of its valuation and has done nothing for the better part of a decade. Investors once loved the growth prospects of Krispy Kreme (KKD) and bid the stock up to very high multiples of earnings and cash flow. When the company failed to hit the lofty growth projections the stock tanked and to date has stayed tanked.

Trying to buy the dip in growth stocks is dangerous, and in my mind border line foolish. Of the big three busts this month, Amazon is probably going to be OK in the long run but a weak Christmas could still compress its PE ratio downward from 87.

In my mind, Netflix is truly broken and may end up being the AOL (AOL) of streaming video. Much like the early leader in Internet services, the company faces competition from larger, better competitors. It is losing the content battle and I doubt it can recover its early advantages. There may be some bounces along the way, but I doubt that this company will ever be a leader in the space again.

I think Green Mountain Coffee is a fad stock and will go the way of all fads. The single-cup coffee maker also is facing competition for Keurig's K-Cup coffee packages and that will pressure margins. On a per-cup basis, the coffee is expensive and if you have more than one coffee drinker in the house, it is not very convenient. I agree with Einhorn on the stock in believing it can go a lot lower.

If you are going to bottom-fish, go out into the deep waters of truly cheap companies. Trying to bottom-fish near the shore among recently broken growth stocks can easily lead to disaster when the tides change.

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